In its report for 2021-26, the 15th Finance Commission of India states that public debt as a share of GDP should continue to serve as the medium-term anchor for fiscal policy in India despite the spending pressures created by the pandemic and investment needs during the recovery phase. Fiscal deficit should be the operational target as recommended by FRBM Act 2003 (amended in 2018). A rule-based framework is credible and transparent, but it must be flexible as well to avoid fragility, states the FC's report.
It argues that extraordinary times like these require growth and income support measures that will unavoidably put upward pressure on public finances. The Commission expects positive interest-growth differentials and adverse debt dynamics over the next two to three years. However, it recommends fiscal consolidation and a declining trajectory for total public debt as a share of GDP over the medium-term.
The FC forecasts fiscal deficit of the union government to be between 3.5% and 4.5% of GDP in FY2026, declining from a range of 6.0% and 6.5% of GDP in FY2022. Given the uncertainties and risks, the Commission outlined fiscal deficit under three scenarios: (i) economy recovery is slower than assessed, (ii) macro-economic assessment holds, and (iii) economic recovery is faster than assessed. In all cases, fiscal deficit is to decrease by 0.5 percentage point of GDP each successive year. It assumes a gradual return to a trend of real GDP growth of around 7% and a less severe than feared effect on workers and businesses due to the pandemic.
For the States, the Commission recommends three options to allow for greater flexibility: (i) additional unconditional borrowing for the first two years to compensate for the loss of tax revenue; (ii) additional borrowing of 0.5 percentage of GSDP in case they meet the criteria for power sector reforms; and (iii) allowing the States to utilize any unutilized borrowing space in the subsequent years within the award period. If the States use the full borrowing space available, then the fiscal deficit, as a share of GSDP, is forecast at 4.5% for FY2022, 4% for FY2023, 3.5% for FY2024 and FY2025, and 3% for FY2026. If the States limit borrowing, on an average, to FRBM threshold, then it will be 3% of GSDP throughout.
Overall, the Commission projects general government fiscal deficit to decline to 9.3% of GDP in FY2022 from 11.6% of GDP in FY2021 and then gradually decrease to 6.8% of GDP in FY2026. The Commission states that it is providing higher fiscal room to both the Center and States to be able to deal with the current pandemic and then the expected economic recovery.
On outstanding general government debt, the Commission expects it to gradually decrease to 85.7% of GDP by FY2026 from a high of 89.8% of GDP in FY2021. The center’s public debt is expected to be 56.6% of GDP by FY2026. Given the prospect of increased borrowing by both the Union and State governments due to large expenditure needs (State government’s expenditure as a share of GDP is greater than that of the Union) in the short-term, there has to be a medium-term debt consolidation effort to ensure a sustainable debt to GDP ratio. Given that the Center’s outstanding public debt will be over 40% of GDP (general government debt 60% of GDP) and fiscal deficit above 3% of GDP for the foreseeable future, the FRBM Act needs to be amended again.
It recommends additional expenditure be used not only to boost investment, but also to strengthen fundamentals to seize new opportunities such as the likely relocation of global production to India, and remote work setting in a distributed economic geography rather than continued growth of the largest cities. The commission prioritizes investment in human capital (especially health and education) and climate change and environmental risks such as air pollution.
The Commission recommended vertical devolution of 41% of resources. For horizontal sharing/allocation of resources, it recommends 15% weight to population, 15% for area, 10% for forest & ecology cover, 45% for income distance, 2.5% for tax & fiscal efforts, and 12.5% for demographic performance.
For revenue deficit grants, a type of grants-in-aid, the Commission recommends an allocation of 1.92% of gross revenue receipts of the Union government. Besides this, there are other performance-based grants-in-aid for sectors such as social sector (health and education sectors focusing on large and particularly vulnerable subset of the population), rural economy (agriculture and maintenance of rural roads), and governance and administrative reforms (judiciary, statistics, and aspirational districts and blocks).
The Commission also estimated that structural ‘tax gap’ for India is over 5% of GDP. It recommends a series of operational and policy reforms to bridge the tax gap such as correcting the inverted duty structure in GST, addressing IT system deficiencies for GST, facilitating complete invoice matching, and reviewing exemptions, thresholds and concessions in income tax.
It argues that India’s fiscal architecture needs to have three mutually reinforcing pillars: (i) fiscal rules that set institutional and budgetary framework for fiscal sustainability; (ii) consistent, reliable, and timely reporting of fiscal indicators; and (iii) ability of fiscal institution to conduct independent assessment to facilitate the first two pillars. This calls for restructuring the FRBM architecture, and constitution of a high-powered inter-governmental group to chart out a new fiscal consolidation framework.
The Finance Commission provides recommendations to the President of India on the distribution of net proceeds of taxes between Center and the States, determination of factors and magnitude governing grants-in-aid to the States, and sound public finance, among others. They operate under a TOR that is different for every Commission and have a tenure of five years.
